Working paper no. 9/2003

02-07-2008

Progression in taxation of earned income, wage formation and labour market performance

The main aim of this paper is to focus on the relevance of theoretical models and empirical work which predict that increased progression in wage taxation may be helpful in reducing structural unemployment, e.g. by reducing the pressure for wage increases. For policy makers this may appear to be a highly attractive double dividend in the context of the increased focus in recent years on improving the work incentives of low skilled workers without reducing economic welfare for unemployed persons. First, reduce replacement rates by lower taxes on wage incomes at the bottom level to improve work incentives for these groups. Second, raise marginal tax rates to finance such reductions while at the same time reducing wage pressures. However, a range of plausible and realistic assumptions about the crucial parameters in labour and product markets gives the opposite results, i.e. more progression leads to increased unemployment. Finally, some policy considerations on the future taxation of wage income are presented. A main argument is a call for a division of labour in economic policy making. For instance, if wage claims are pushed up by union rent seeking in (semi) monopoly industries this should be addressed through competition policies, not by raising marginal tax rates on labour income which, as widely recognised, may have negative effects on the economy’s longer term potential.

Progression in taxation of earned income, wage formation and labour market performance

Author: Helge Sigurd Næss-Schmidt